The global fight against inflation is not over yet

At first it appeared that much of the problem was due to the fact that central banks were late to the fight. In the early stages they faltered under the mistaken belief that inflation was “temporary”. It took them a while to understand that the inflation problem was a serious, global, once-in-a-generation phenomenon, driven by a complex mix of factors. : supply disruptions due to the pandemic and consequential lockdowns, fiscal excesses by governments financed by excessively loose central bank monetary policies, additional supply-side shocks due to Russia’s invasion of Ukraine, and an increase in corporate pricing power that was last seen . second World War.

The pressure on the supply side has now eased considerably. Central banks have increased interest rates by an average of 300 to 500 basis points. But central bank governors in the US and Europe have said they do not expect inflation to return to target levels anytime before 2025. The Bank of England recently raised its policy rate by 50 basis points and the Fed is expected to raise rates it’s July meeting.

Even the Reserve Bank of India (RBI) – which is not expected to hike interest rates – is adamant that it may not start lowering them anytime soon, even though inflation has declined faster in India than in advanced economies Is. The RBI is worried that the battle is not yet won as the softening of prices may not continue, especially in the face of fresh shocks like El Nino.

Part of the caution comes from the fact that – especially in advanced countries, but also in India – while headline inflation has declined, given that the fuel shock following Russia’s invasion of Ukraine is now behind it, Core inflation (which excludes energy and food prices) is still very high. It is still above 5% in both the US and the euro area. This leaves central banks with no option but to continue raising interest rates.

One reason for this is that central banks breached the neutral rate (the level at which they begin to reduce demand) a few months ago. The basic rule is that monetary policy usually shows results with a lag of about 18 months. Interest rates start rising in May 2022, not even 18 months yet.

The nature of inflation in advanced economies also makes it difficult to deal with. Persistently high inflation reflects acute shortages in supply, particularly in labor markets. Labor markets are tight as people are unwilling or unable to return to work. Since wage growth is still strong, the US unemployment rate has declined only modestly, and growth there remains resilient despite decade-high interest rates, should the Fed keep raising rates. By one estimate, for inflation to return to the Fed’s target level of 2%, unemployment must rise to 6.5%, putting five million more people out of work.

Here’s how monetary policy works. Central banks destroy demand until its gap with supply narrows enough to reduce price pressure. But if they do so too soon, they could create new risks. This is because Covid-relief spending has widened the government budget deficit to a level not seen since World War II. Funding them requires central banks to keep monetary liquidity loose, as opposed to raising interest rates.

Central banks cannot raise interest rates so quickly or else they may put financial stability at risk. When interest rates rise from zero to nearly 500 basis points in a matter of months, banks suffer losses on some of their securities, resulting in bank runs, asset-liability mismatches, bankruptcy and disaster. The collapse of Silicon Valley Bank and Credit Suisse Has shown.

Updated: July 09, 2023, 02:05 PM IST